Why the Value Add Apartment Investment Is A Great Investment
A few years ago, I came across an old bookshelf on the side of the road. It had been neglected and had a “free” sign on it, but it was in decent shape, and I could envision a new life for it, so I lugged it home.
I sanded it down, painted it with bright colors, and found a nice spot for it in our apartment. When we moved, we no longer had a place for it, so we sold it to someone else, who loved the colors and found a great use for it.
I’d taken something that others had overlooked, put in some sweat equity and vision, and breathed new life into it. This is the essence of value-add, and it’s a strategy commonly used in real estate investing.
The Basics of Value-Add Real Estate
In the world of single-family homes, value-add is commonly referred to as fix-and-flip. You take a run-down property, reimagine it, invest money to rehab it, and sell it to a new owner, for a profit. You receive a monetary reward for the work you put in and the risk you undertook, and the new owner gets a beautiful new property that’s move-in ready.
In the multifamily world, value-add is similar to the fix-and-flip model, but on a massive scale.
Instead of renovating a single unit, we’re often renovating hundreds of units, over several months or years.
A value-add multifamily property is one that comes with things like peeling paint on building exteriors, brown grass or overgrown bushes, kitchens with old appliances, and more. These are all cosmetic upgrades that can improve the community and increase the income the property produces.
The goal of every improvement is twofold. One is to improve the unit and community, for the tenants. The other goal is to either directly or indirectly increase the bottom line, for the investors.
Common value-add renovations can include individual unit upgrades, such as:
In addition, adding value to exteriors and shared spaces often helps to increase the sense of community:
Fresh paint on building exteriors
Shared spaces (BBQ pit, picnic area, etc.)
On top of all that, adding value can also take the form of increasing efficiencies:
Green initiatives to decrease utility costs
Decreasing your taxes by disputing the bill.
Shared cable and internet
The Logistics of a Multifamily Value-Add
Most people are pretty familiar with the basic single-family fix-and-flip model at this point. You buy a vacant property, renovate it over the course of weeks or months, sell it, and the new owner moves in.
Once those tenants vacate their old units, the renovations ensue with freshly vacated units, and the process repeats until most or all of the units have been updated.
When we’re talking about hundreds of units, however, the renovation schedule and logistics aren’t as intuitive. How do you renovate the property when there are people living in it? Do you kick people out? How many do you do at a time? All great questions.
When renovating a multifamily property, we always start with vacant units.
In a 100-unit property, a 5% vacancy rate means that there are five vacant units right off the bat, so our renovations begin there.
Once those are done, the goal is to renovate the large majority of the remaining units within the next eighteen months or so. This is done in a rolling fashion.
As each tenant’s lease comes due, we offer to move that tenant into an upgraded unit. We never kick anyone out of their homes. More often than not, tenants are blown away by the upgrades and are more than happy to pay a little extra to get to live in the brand new units.
Once those tenants vacate their old units, the renovations ensue with freshly vacated units, and the process repeats, until most or all of the units have been updated
During the course of this process, some tenants do elect to move out, and we always factor into our business plan and projections a temporary increase in vacancy rates to account for the turnover and potential new lease-ups.
Why We Love Investing in Value-Add Properties
When done right, value-add strategies often result in a win-win scenario.
Through renovating the units, we can provide tenants a nicer place to live (tenants win). And through increasing the rents to market rates, we can drastically increase the equity in the property (investors win).
The part where tenants win because they now have a nicer place to live is probably pretty straightforward. So let’s focus on the investor win, and why value-add can be a great investing strategy.
First, Let’s Talk about Yield Plays
To fully appreciate the benefit of a value-add investment, we should first examine its counterpart, the yield play investment.
Let’s say we buy a 100-unit apartment building that’s already in pretty good shape, and it gets decent cash flow as is, so we decide to just buy it and hold it, without doing much to improve the property.
Essentially, we’re buying a stabilized property, and we’re investing in it for the potential yield down the road. This is called a yield play.
Perhaps the market might go up, and then we can sell for a hefty profit, as long as there is no deferred maintenance. But, there’s always the chance that the market will hold steady, or even contract, in which case we might not make as much as projected.
In a yield play like this, we’re buying a stabilized asset and holding it for potential future profits. The keyword there being potential. We have no control over the local market; we can only go based on historical data and our best guesses at future projections.
In a yield play, we’re depending on cash flow and market appreciation for the bulk of our investment returns.
Distressed Asset - These are the riskiest investment of all.
These are the riskiest investment of all. The vacancy is high. Many of the units are down and in disrepair. It is oftentimes filled with - let's just call them - undesirable tenants. Tenants that not only don't pay their rent but do some other extracurricular activities that don't, well... contribute to the community, shall we say. The building needs to be "repositioned" from a distressed asset into a stabilized, well-performing asset, and it is not for the faint of heart. It is most definitely a heavy lift. The risk and work increase 10-fold if you are in a bad neighborhood because now you are tasked with bringing up the whole neighborhood. It is hard work - people can make a killing - but it comes with a high degree of risk.
Back to Value-Adds
The combination of yield and the distressed asset is the Value-Add. While not totally distressed, it is need of some upgrades due to maintenance being deferred, and current ownership not managing the property well.
A value-add can also come with a ton of potential upside.
The main investor benefit in a value-add investment is that we, as investors, hold all the cards. We can actively do something (i.e., renovate the property) to increase value, rather than just sit around and wait for the market to appreciate.
Through improving the property, we can increase the income, hence also increasing our equity in the deal (remember, commercial properties are valued based on how much income they generate, not on comps, like single-family homes).
This gives us much more control over the investment and the returns than in a yield play, which relies primarily on market appreciation for its upside.
Of course, this hybrid is ideal. This is when you invest in a value-add asset in a growing market. You have control over a certain amount of value that can be added, and you’re also in a market that will likely add some bonus appreciation on top of that.
It's not all rosie. There are risks in Value Add as well.
Risk in Value-Add Investments
Have you ever watched one of those fix-and-flip shows on HGTV? There isn’t a single show without drama.
They pulled up the flooring and found foundation issues. They struck a water main while in the midst of renovations. Unexpected storms/flooding/earthquakes/other natural disasters created setbacks in the timeline. You get the idea.
These are all risks that investors have to take into account when taking on a value-add project.
When you’re making changes to anything, there’s always the risk that something might not go according to plan.
When we evaluate deals to decide whether we want to invest in them ourselves, we’re always looking for sponsors who have capital preservation at the forefront (i.e., their number one goal is not to lose our initial investment) and who have a number of risk mitigation strategies in place, including:
Proven business model (e.g., some units have already been upgraded and are achieving rent increases)
Experienced team, particularly the project management team
Multiple exit strategies
The budget for renovations and capital expenditures is raised up front, rather than through cash flow
Value-add investments are powerful vehicles of wealth. They come with serious potential upside, but along with that upside comes risk. That’s why we work hard with sponsors to put in as many risk mitigation strategies as possible, to ensure that we’re turning over every stone and protecting investor capital at all costs.
Recap and Conclusion
All in all, no investment is free of risk. However, we’re of the opinion that value-add investments, despite their potential risks, provide greater benefits to both the investors and to the communities.
By leveraging investor capital in a value-add investment, we’re able to help drastically improve apartment communities, thereby creating cleaner and safer places to live and putting more smiles on tenants’ faces.
And because we can decide when and how to execute the renovations, we have more control over the investment, rather than relying solely on market appreciation, thereby creating more levers and options to safeguard our investment and maximize returns.
Value-add investments are a true win-win, which is one of the reasons we love them.